The Legal Way Canadian Marijuana Stocks Are Tricking Investors

The wait is over. Following nine decades of prohibition, recreational marijuana is officially legal in Canada, albeit the extent of who can buy, whether the plant can be homegrown, and where product can be purchased really depends on the province.

The important fact here is that legalization is expected to usher in billions of dollars of added annual revenue to the industry. This expectation of a surge in sales -- Wall Street is looking for approximately $5 billion in added annual revenue once the industry is up to speed -- is what's behind the more than two-year rally in marijuana stocks. Mind you, many of the largest pot stocks have increased in value by 1,000% or more since the beginning of 2016.

Two rows of trimmed cannabis buds covering hundred-dollar bills.

Image source: Getty Images.

Some of these marijuana stocks have really been turning heads by generating early-stage profits and presumably setting the stage for a genuine green rush. For example, CannTrust Holdings(NASDAQOTH: CNTTF) has generated a profit in each of the past two quarters, putting it on track to report CA$0.11 (0.11 Canadian dollars) in earnings per share for its current fiscal year, based on Wall Street's consensus. Other profitable growers of late include OrganiGram Holdings(NASDAQOTH: OGRMF) and Aphria(NASDAQOTH: APHQF).

But what if I told you that these profits were a completely legal sham?

IFRS accounting could make marijuana stock investors look foolish

Let's face it, the marijuana industry is difficult for most folks to understand, mainly because it's been an underground industry for the past nine decades in Canada. But the reporting standards that marijuana growers are required to follow make things exceptionally hard for the average investor to process.

In Canada, publicly traded companies are required to report their income statement using International Financial Reporting Standards, or IFRS. One of the weird quirks about IFRS is how agricultural products are accounted for. When it comes to pot stocks, growers are required to recognize the fair value of their biological assets, minus their selling costs, prior to actually selling these assets.

A magnifying glass being held over a balance sheet.

Image source: Getty Images.

I'll go ahead and repeat that for those of you who might be skimming. Basically, marijuana growers have to "guestimate" how much their crop is worth -- and keep in mind that the value of a crop can vary based on the various stages of plant growth -- and then also guestimate how much their selling costs will be... before the crop is ready. Because cannabis plants go through various stages of their growth cycle, the fair value estimate can change... a lot.

Now, if this isn't confusing enough, Canadian agricultural companies with biological assets (i.e., cannabis plants) were given the option to determine where on their income statement they'd recognize this fair value adjustment, which, as noted, will require regular changes. Publicly traded Canadian pot stocks chose to recognize fair value as an above-the-line figure, meaning it's wound up reducing the cost of sales in the early going. In other words, fair-value adjustments for biological assets can artificially bump up profits based on how much cannabis is being grown and according to the life cycle of a grower's crop.

Mind you, all of this is 100% legal according to IFRS accounting. But truth be told, these early-stage profits are a complete sham.

Here's what's really going on under the hood

If we were to scrape away the perfectly legal frosting (i.e., IFRS biological asset accounting) that pot stocks have been using, we'd see a much grimmer picture, at least in the near term.

An accountant chewing on a pencil while critically looking at figures printed out by his calculator.

Image source: Getty Images.

For instance, hydroponic-focused grower CannTrust Holdings has generated CA$16.89 million in revenue through the first six months of its current fiscal year, with cost of goods sold, sans biological asset adjustments, of CA$8.05 million. However, operating expenses, such as selling and shipping costs, share-based compensation, marketing and promotion, and all those other normal costs that are somehow being forgotten totaled CA$18.32 million year to date. In other words, without IFRS accounting, CannTrust has probably lost closer to CA$10 million so far this year on an operating basis.

It's the same story for OrganiGram Holdings and Aphria. For OrganiGram, it's generated CA$10.1 million in sales over the past nine months, with cost of goods sold of CA$5.09 million. But OrganiGram's expenses totaled CA$12.99 million, sans fair-value adjustment, leading to a crude operating loss of CA$8 million.

As for Aphria, in its latest quarterly operating results, it reported CA$13.29 million in sales and just over CA$4.8 million in production and "other" costs. However, operating expenses totaled a whopping CA$24.12 million, leading to a nearly CA$16 million operating loss if biological adjustments are excluded.

In short, marijuana stocks are playing a perfectly legal trick on investors who simply don't want to dig into what's actually going on. Now, this isn't to say that these companies won't be genuinely profitable in the future with the product now legal in Canada. But if we dig a bit deeper, it does suggest that pot stocks are still nowhere near profitability on a purely operating basis -- and that's what should matter to investors.